Market Efficieny : Anomaly from CDS and Loan CDS

There was a unique study done recently paper titled “MARKET EFFICIENCY AND DEFAULT RISK: EVIDENCE OF AN ANOMALY FROM THE CDS AND LOAN CDS MARKETS” by Lawrence Kryzanowski, Stylianos Perrakis and Rui Zhong.

The findings where significantly positive pricing-parity deviations from a simulated portfolio that simultaneously participates in opposite legs of the undervalued and overvalued contracts in the CDS and LCDS markets for exactly the same underlying firm, maturity, currency and restructure clauses. These deviations cannot be accounted for by trading costs, illiquidity or imperfect data about recovery rates in the event of default, suggesting segmentation between CDS and LCDS markets. Using panel regressions, we find that firm-level informational asymmetry and loan-recovery difficulty in case of default are more important than macroeconomic factors in accounting for the pricing-parity deviations.

Credit Default Swaps (CDS) and Loan CDS (LCDS) contracts are essentially financial agreements between protection buyers and protection sellers to transfer the credit risk of the underlying assets (respectively, corporate debts and syndicated secured loans). The more recent LCDS market has grown quickly since its inception in 2006, fueled by the rapid growth in its underlying asset market. Compared to traditional CDS contracts, LCDS contracts have higher recovery rates and cancellability options. Unlike the CDS market, the LCDS market has not been studied extensively in the existing literature due to lack of data.

The data source was Markit to construct a simulated portfolio to exploit deviations from current pricing-parity by participating simultaneously in both markets.